Attorney Shao Shiwei | What Criminal Legal Risks Arise from Engaging in DeFi Within China?

 

Author: Attorney Shao Shiwei

01

 

What Is DeFi?

 

DeFi (Decentralized Finance), or “decentralized finance,” stands in contrast to CeFi (Centralized Finance), or “centralized finance.”

Banks, stock exchanges, and other institutions within the existing financial system are examples of CeFi. DeFi can be viewed as a parallel world to traditional finance. The DeFi financial stack consists of five main components: stablecoins, exchanges, money markets, synthetic assets, and insurance. Stablecoins serve as a bridge between fiat currencies and virtual currencies and play a significant role in the DeFi financial system. Decentralized exchanges enable users to conduct peer-to-peer transactions without intermediaries. DeFi money markets are fully transparent, allowing anyone to view at any time the volume of loans issued from lending pools to ensure sufficient crypto assets support outstanding loans. Synthetic assets represent financial instruments composed of derivatives of one or more assets; that is, they are not underlying assets but rather synthesized. For example, the US dollar is an underlying asset, while USDT is a synthetic asset introduced onto the blockchain pegged to the US dollar. Insurance is divided into centralized and decentralized insurance; decentralized insurance offers faster claims settlement and greater flexibility.

 

 

02

 

DeFi Applications and Common Risks

 

DeFi facilitates the flow and allocation of funds through smart contracts rather than third-party centralized organizations. It is commonly applied in the following areas:

 

1. Lending. In DeFi lending, transactions are executed via smart contracts, and lending typically involves over-collateralization.

2. Financing. Financing on the blockchain is conducted in exchange for tokens (ICO).

3. Derivatives. For example, Synthetix is an Ethereum-based protocol for issuing synthetic assets. Users can mint, hold, and trade various synthetic assets, thereby gaining long and short exposure to related assets.

4. Decentralized Trading. For example, Uniswap, a DEX (decentralized exchange), allows users to trade directly on-chain without intermediaries.

 

Currently, DeFi-related applications still entail substantial risks.

 

1. Due to the lack of regulatory oversight, potential security vulnerabilities and instability in DEXs expose users to risks concerning fund security and liquidity.

2. Given the irreversibility of smart contracts, transactions cannot be revoked once completed. If users suffer fraud or make operational errors during transactions, losses may be difficult to recover.

3. Funding for projects within the DeFi ecosystem derives from liquidity provided by users. If a large number of users withdraw funds simultaneously, it may lead to insufficient liquidity, thereby triggering risks.

 

 

03

 

Criminal Risks Associated with Operating DeFi Projects

 

China classifies virtual currency-related activities—such as exchanging fiat currency for virtual currencies, token issuance financing, and derivatives trading—as illegal financial activities. Therefore, engaging in DeFi may involve the following criminal legal risks.

 

1. Crime of Illegal Business Operations

As a parallel world to the traditional financial system, DeFi provides products and services such as lending, asset management and wealth management, insurance, and derivatives. Under the Criminal Law, engaging in such businesses without obtaining the requisite qualifications or licenses constitutes the crime of illegal business operations. DeFi products that provide collateralized lending and support payment and settlement between virtual currencies and fiat currencies, using virtual currency transactions as a medium for related financial services, may be suspected of constituting the crime of illegal business operations.

 

2. Crime of Illegally Absorbing Public Deposits; Crime of Fundraising Fraud

Project issuers may launch “meme coins” or “copycat coins” and then promote them through communities, key opinion leaders (KOLs), roadshows, and other channels to induce domestic users to purchase them on DEXs. If the project operators abscond, investors become victims of exploitation. If investors collectively seek recourse and file reports with authorities, the project operators may be suspected of committing the crime of illegally absorbing public deposits or the crime of fundraising fraud.

 

3. Crime of Organizing and Leading Pyramid Schemes

Virtual currency mining projects that falsely claim to engage in DeFi mining and adopt a model of earning returns through liquidity mining by staking LP tokens, but in substance rely on entry fees paid per participant as the basis for rebates, may be suspected of constituting the crime of organizing and leading pyramid schemes.

 

4. Crime of Opening a Casino; Crime of Gambling; Crime of Organizing Participation in Overseas Gambling

Due to the anonymity and decentralization inherent in blockchain technology, along with the use of smart contracts, gambling games can be developed and designed on blockchain infrastructure. If GameFi (Game + DeFi, i.e., blockchain games) with gambling elements features the ability to cash out game tokens, it may constitute gambling-related offenses under China’s Criminal Law.

 

In light of the above, industry participants have adopted indirect approaches by establishing DeFi-related businesses abroad to evade Chinese regulation. Thus,If a project is operated overseas while individuals in China exercise “remote control,” can they rest assured?The answer is no.

 

China’s Criminal Law stipulates jurisdiction based onterritorial principles and personal principles.Territorial jurisdiction means that China exercises jurisdiction if either the criminal act or its consequences occur within Chinese territory. Personal jurisdiction means that China also exercises jurisdiction over Chinese nationals who commit crimes outside Chinese territory.

 

According to Article 2 of the Interpretation of the Criminal Procedure Law of the People’s Republic of China (2021), for crimes committed against or primarily utilizing computer networks, the place of the crime includes the location of servers used for network services employed in committing the criminal act, the location of the network service provider, the location of the infringed information network system and its administrator, the location of the information network systems used by the defendant and the victim during the commission of the crime, as well as the location of the victim at the time of infringement and the location where the victim suffered property losses.

 

Therefore, China has jurisdiction whenever a Chinese national commits a crime, or when the criminal act or its consequences occur within China.

 

Furthermore, under the provisions below, individuals providing services such as marketing and promotion, payment and settlement, and technical support bear liability.

According to Section I(3) of the Notice on Further Preventing and Disposing of Risks Related to Virtual Currency Trading and Speculation, overseas virtual currency exchanges providing services to residents within China via the internet likewise constitute illegal financial activities. Domestic staff of relevant overseas virtual currency exchanges, as well aslegal persons, unincorporated organizations, and natural persons who, knowing or should have known that such parties were engaged in virtual currency-related businesses, still provided them with marketing and promotion, payment and settlement, technical support, or otherservices, shall be held legally accountable.

 

 

04

 

Conclusion

 

The internet knows no borders, and criminal risks transcend national boundaries. Operating DeFi projects abroad, even if Chinese IP addresses are blocked, does not guarantee that Chinese nationals will not use the relevant services, nor does it effectively evade criminal legal risks under Chinese law.